ASX warns on dark pools

The Australian Securities Exchange has stepped up calls to curb the growth of “dark pools" amid concerns high frequency traders are driving investors away from traditional exchanges, reducing market liquidity and the ASX’s revenues.

ASX deputy chief executive
Peter Hiom
told The Australian Financial Review that “absent any regulatory framework [the ASX] will act in the way which we think ensures that we comply with our licence obligations and remain a profitable enterprise, but we don’t think that allowing the dark pools to simply just evolve . . . is in the interest of the market."

The Australian Securities and Investments Commission and the ASX have together, over the past year, been monitoring the rise of high frequency trading (HFT). By matching clients’ buy and sell orders away from the exchange in dark pools, investment banks seek to prevent information leakage, or the risk that HFT firms will spot a large trade and try to profit from their clients’ orders. The ASX estimates 30 per cent of trades are now done off market, with dark pools accounting for 4 per cent of all trades.

HFT firms automatically generate large numbers of orders based on price movements and market information and typically hold positions for a very short time, ending the day with a zero position. HFT is estimated to account for 25 per cent of trading on the ASX. Today’s Capital magazine, inserted in the AFR, explores the growth of HFT and the strategies being employed by the leading firms.

Brokers have always had some opacity around larger orders to prevent information leakage, but the ASX now fears more regular trades are taking place in the dark pools.

“Now dark pool operators are wont to, in our view, stretch the rules to apply to an order of any size, as opposed to those large transactions and they are now starting to look very much like quasi exchanges but with none of the obligations," Mr Hiom said.

As dark pools grow, fewer buyers and sellers are meeting on the ASX or Chi-X – the “lit" markets – leading to lower volumes, and wider spreads on those exchanges.

“The unintended consequences of this fragmentation, which was intended to drive liquidity, is it is actually driving some users out of the central market," Mr Hiom said. “It is unclear how dark pools operate. Not everyone has access to them, the prices at which they trade are not transparent, the rules under which they operate are not governed by ASIC, the way in which orders are matched is not transparent and the fees under which they operate are not transparent."

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The ASX says its primary concern is market integrity, estimating that the impact of dark pools on its business model, for now, is modest, affecting only 6 per cent of its revenues.

Investment banks say HFT funds are the problem, not dark pools.

Goldman Sachs head of advanced trading strategies, Deepan Pavendranathan, runs the bank’s dark pool, Sigma X. He said a potential solution could be to introduce stamp duty for all trades.

“Dark pools have become more popular because the lit markets have become a more difficult place to trade," he said.

“A decade ago, our clients were only trading against other long-term holders of stock. Now up to 40 per cent of the time our clients are trading against participants with an average holding time of less than a minute."

This year ASIC started charging a fee based on the number of messages sent to an exchange to discourage high frequency arbitrage strategies. In response to dark pools, the regulator has refined its proposals for market structure reform and issued a timetable for implementing the regulatory framework, with final rules due in October. But for now the practice remains unregulated.

In a speech at a stockbrokers’ conference last month, ASIC chairman
Greg Medcraft
said dark pools were an urgent issue for the regulator to address. “Even though most of the dark liquidity is priced by reference to the prices on the lit markets, research suggests that increased flows of dark liquidity can widen spreads on the lit market, resulting in everyone being worse off," he said.

ASIC plans to make new rules limiting ‘dark’ orders to a maximum of $200,000 for the majority of stocks, down from $1 million. ASIC is creating a taskforce to review dark pools and other forms of off-market trading.